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Do Hedge Funds Exploit Rare Disaster Concerns?"

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Do Hedge Funds Exploit Rare Disaster Concerns? Do Hedge Funds Exploit Rare Disaster Concerns? George P. Gaoy, Pengjie Gaoz, and Zhaogang Songx First Draft: July 2012 This Draft: July 2016 Abstract We …nd hedge funds that have higher return covariation with a disaster concern index, wihch we develop through out-of-the-money puts on various economic sector indices, earn signi…cantly higher returns in the cross section. We provide substantial evidence that these funds have better skills in exploiting the market’s ex ante rare disaster concerns (SED), which may not realize as disaster shocks ex post. In particular, high-SED funds on average outperform low-SED funds by 0:96% per month, but have less exposure to disaster risk. They continue to deliver superior future performance when SED is estimated using the disaster concern index purged of disaster risk premium, and have leverage-managing and extreme-market-timing abilities. We also provide strong evidence against alternative interpretations. Keywords: Rare disaster concern; hedge fund; skill JEL classi…cations: G11; G12; G23 We would like to thank Warren Bailey, Sanjeev Bhojraj, Craig Burnside, Martijn Cremers, Zhi Da, Christian Dorion, Itamar Drechsler, Ravi Jagannathan, Bob Jarrow, Alexandre Jeanneret, Andrew Karolyi, Soohun Kim, Veronika Krepely, Tim Loughran, Bill McDonald, Roni Michaely, Pam Moulton, Narayan Naik, David Ng, Maureen O’Hara, Sugata Ray, Gideon Saar, Paul Schultz, David Schumacher, Berk Sensory, Mila Getmansky Sherman, Laura Starks (the editor), Shu Yan, Jianfeng Yu, Lu Zheng, Hao Zhou, and two anonymous referees for their helpful discussions and comments, as well as seminar participants at the City University of Hong Kong, Cornell University, HEC Montreal, University of Notre Dame, the 2013 China International Conference in Finance, the 2013 EFA Annual Meeting, the 2013 FMA Annual Meetings, the 2014 MFA Annual Meetings, the 2015 AFA Annual Meetings, the 3rd Luxembourg Asset Management Summit, the 6th Paris Hedge Fund Research Conference, Texas A&M University, and University of Hawaii. We are especially grateful to Zheng Sun for help on clustering analysis; Kuntara Pukthuanthong for data on benchmark factors; and Sang Seo and Jessica Wachter for data on model-implied option prices. Financial support from the Q-group is gratefully acknowledged. The RIX index and its components are available from authors’ websites for academic use. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by the Board of Governors of the Federal Reserve System. ySamuel Curtis Johnson Graduate School of Management, Cornell University. Email: [email protected]; Tel: (607) 255–8729 zFinance Department, Mendoza College of Business, University of Notre Dame. E-mail: [email protected]; Tel: (574) 631-8048. xCarey Business School, Johns Hopkins University. E-mail: [email protected]. Tel: (410)-234-9392 2 1 Introduction Prior research on hedge fund performance and disaster risk focuses on the covariance between fund returns and ex post realized disaster shocks. In the time series, a number of hedge fund investment styles, characterized as de facto sellers of put options, incur substantial losses when the market goes south (Mitchell and Pulvino (2001) and Agarwal and Naik (2004)). In the cross section, individual hedge funds have heterogeneous disaster risk exposure, and funds with larger exposure to disaster risk usually earn higher returns during normal times, followed by losses during stressful times (Agarwal, Bakshi, and Huij (2010); Jiang and Kelly (2012)). At its face value, the existing evidence suggests that hedge funds are much like conventional assets in an economy with disaster risk: they earn higher returns simply by being more exposed to disaster risk. We provide novel evidence that some hedge fund managers with skills in exploiting ex ante market disaster concerns, which may not be realized as ex post disaster shocks, deliver superior future fund performance while being less exposed to disaster risk. Our basic idea is illustrated in Figure 1, which plots the monthly time-series of a rare disaster concern index (RIX) we construct using out-of-the-money put options on various economic sector indices. The index value at time t is essentially equal to the price of insurance against extreme downside movements of the …nancial market from time t to (t + ) in the future (see Section 2 for details). The graph shows the following salient feature of the market’sdisaster concerns. When market shocks occur at time t, concerns for future disasters between t and (t+) increases substantially. Most importantly, the magnitude of such increased concerns at time t seems to be enormous relative to subsequently realized losses, if any, between t and (t + ).1 This startling di¤erence between the ex ante disaster concerns and the ex post realized shocks suggests that investors may be paying a “fear premium”beyond the compensation for the disaster risk. In fact, Bollerslev and Todorov (2011) suggest that the fear premium is a critical component of market returns. Such a fear premium can be consistent with the behavior of agents with non-expected utility or constrained agents who face market frictions and are averse to tail events (Liu, Pan, and Wang (2005); Bates (2008); Caballero and Krishnamurthy (2008); Barberis (2013)), or consistent 1 Another feature of disaster concerns is that the index spikes not only when disaster shocks hit the market such as the LTCM collapse, the crash of Nasdaq, and the recent …nancial crisis, but also during bull markets such as the peak of Nasdaq and the market rally in October 2011. 1 with market mispricing or sentiment (Bondarenko (2004); Han (2008)). Under these circumstances, hedge fund managers with better skills in exploiting such disaster concerns or “fear premium”could deliver superior future fund performance. How can some hedge funds exploit such ex ante disaster concerns better than others while being less exposed to the ex post realization of disaster shocks? First, some fund managers may be better than others at identifying market concerns that are fears with no subsequent disaster shocks. By supplying disaster insurance to investors with high disaster concerns, some fund managers pro…t more than others who do not possess such skills and are thus unable to take advantage of these opportunities.2 Second, even when disaster concerns are subsequently realized as disaster shocks, some fund managers may be better than others at identifying whether there is a “fear premium” beyond the compensation for realized shocks. By extracting such a “fear premium”, they pro…t more than others who do not possess such skills. Third, “di¢ culty in inference regarding ... severity of disasters ... can e¤ectively lead to signi…cant disagreements among investors about disaster risk” (Chen, Joslin, and Tran (2012)). Di¤erent investors can have di¤erent disaster concerns with di¤erent levels of “fear premium”when the market’sdisaster concern is high, regardless of whether it is followed by a realized disaster shock or not. Some hedge fund managers may have better skills at identifying the investors who are willing to pay higher premiums for disaster insurance. From an operational perspective, even some of the standard …nancial insurance contracts, including options on …xed-income securities, currencies, and a subset of equities, are traded on over-the-counter (OTC) markets. Thus, hedge funds with di¤erent networks may have di¤ering ability to locate investors who are willing to pay high premiums. In summary, skills in exploiting disaster concerns can contribute to higher returns for certain hedge funds, and at the same time not necessarily make them more exposed to disaster shocks. While the covariance between hedge fund returns and ex post realized shocks helps us to under- stand hedge fund risk pro…les, it is the covariance between hedge fund returns and ex ante disaster concerns that helps us to identify skillful fund managers. In principal, when the market’s disaster concern is high, funds with more skilled managers should earn higher contemporaneous returns 2 “Supplying disaster insurance”here does not literally mean hedge funds write a disaster insurance contract to investors. As argued by Stulz (2007), hedge funds, as a group of sophisticated and skillful investors who frequently use short sales, leverage, and derivatives, are capable of supplying earthquake-type rare disaster insurance through dynamic trading strategies, market timing, and asset allocations. 2 than those with less skilled managers in supplying disaster insurance. Empirically, we measure fund skills in exploiting rare disaster concerns (SED) using the covariation between fund returns and the disaster concern index we construct.3 Consistent with our view that hedge funds exhibit di¤erent levels of skills in exploiting disaster concerns, we document substantial heterogeneity of SED across hedge funds as well as signi…cant persistence in SED. Our main tests focus on the relation between the SED measure and future fund performance. In our baseline results, funds in the highest SED decile on average outperform funds in the lowest SED decile by 0:96% per month (Newey-West t-statistic of 2:8).4 Moreover, high-SED funds exhibit signi…cant performance persistence. The return spread of the high-minus-low SED deciles ranges from 0:84% per month (t-statistic of 2:6) for a three-month holding horizon, to 0:44% per month (t- statistic of 1:9) for a 12-month holding horizon. We also show that the outperformance of high-SED funds is pervasive across almost all hedge fund investment styles. These results are inconsistent with the view that hedge funds earn higher returns on average simply by being more exposed to disaster risk. If the SED measure, as the covariation between fund returns and the disaster concern index, is interpreted as measuring disaster risk exposure, high-SED funds on average should earn lower returns (rather than the higher returns we document) because they are good hedges against disaster risk under this interpretation.
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